“Investors are increasingly needing to respond and analyse the reaction function of central banks because that’s the key driver of markets today,” she said.

Advertisement

Advertisement

Ms McNaughton said central banks and markets are locked in a “reflexive feedback loop” whereby central banks respond to how markets respond to them.

The subsequent volatility created by central banks will likely continue for at least the next 12 to 18 months, she said. For investors, a greater portion of their portfolio therefore needs to be allocated to tail risk hedges.

“You make sure that you have part of your portfolio that’s directed towards alpha generation but part of your portfolio now has to be escrowed into an allocation that is designed to benefit from surprises,” Ms McNaughton said.

She said investors must analyse what risks are evident in markets and hedge accordingly. Investors must also prioritise the risks they want to protect against because not all risks can be targeted.

“It does mean that you won’t have 100 per cent of your portfolio now directed towards alpha generation so that implies lower returns,” Ms McNaughton said.

“But if you want to protect your portfolio against the volatility, this unfortunately is where we’re at.”